quantstrategy20130523-choose your own adventure capex cliff edition.pdf

Equities Research Quantitative Strategy

Issued by Wilson HTM Ltd ABN 68 010 529 665 - Australian Financial Services Licence No 238375, a participant of ASX Group and should be read in conjunction with the disclosures and disclaimer in this report. Important disclosures regarding companies that are subject of this report and an explanation of recommendations can be found at the end of this document.

ACTION & RECOMMENDATION

We got an update today from the Bureau of Resources and Energy Economics (BREE) on the state of mining projects and in our view the data paints a bleaker picture than BREEs interpretation. In particular we note that our analysis of greenfield / brownfield projects, projects by major vs junior miners and floating liquified natural gas (LNG) projects suggest of a fall in capex of 1 to 1.5% of GDP for each of the next three years. Further we note even a house building boom would not be enough to offset that fall the Australian economy needs traditional industrial sectors to increase capex which will need a much lower dollar and lower interest rates.

Damien Klassen

[email protected] Tel. +61 2 8247 3101

In this report we present a range of scenarios depending on the assumptions about which types of projects go ahead. The most bullish

scenarios suggest capex will continue to increase as a % of GDP, the

most bearish look like subtracting 1.5 to 2% per annum from GDP.

Over the last 3 years mining capex has added about 1 to 1.5% to GDP growth per year. Over the next 3 years on our base case mining capex

is likely to subtract 1 to 1.5%% from GDP growth.

Going forward there are likely to be a large number of projects deferred given: commodity prices have peaked; many major resource

companies have new CEOs with a focus on shareholder returns rather

than growth; junior resource companies are struggling to get finance.

While floating LNG projects will add to headline capex, most of the spend will be offshore and so after netting off imports the actual

Australian capex will be much lower as much as 1% of GDP by 2016.

A house building boom is unlikely to make back more than 1% of the 3-4% decline in capex as a % of GDP. The rest would require spending

in other economic sectors to pick up which is unlikely in our view

without a substantially lower Australian dollar and / or interest rates.

FIGURE 1: MINING CAPEX AS A % OF GDP

Key assumptions used

% of Floating LNG projects

imported 85%

Base Case:

% projects in feasibility going ahead before 2016

80%

Cost blowout on all projects +10%

Discounts to Base Case:

- Greenfield Projects -20%

- Mid Tier Miner -20%

- Junior Miner -50%

- No Feasibility Study -50%

Mega Projects going ahead before 2016: Browse, Dudgeon, Sunrise, Scarborough, Gorgon (T4), Alpha Coal,

Roy Hill, Galilee Coal, Carmichael Coal.

Source: Wilson HTM, BREE

22 May 2013

QUANTITATIVE STRATEGY

Choose Your Own Adventure: Capex Cliff Edition

Capex in our view

will fall almost as

fast as it rose.

We note a growing difference if

we adjust floating LNG projects for

the proportion imported

8 April 2012

Economic Strategy

Tactical Asset Allocation

Equities Research Quantitative Strategy 2

The BREE data (http://www.bree.gov.au/) gives a detailed breakdown of around 380

resource projects including classification, project owners, capex estimates and timing

estimates.

In the first part of this report (below) we use the BREE data to run a number of

scenarios estimating mining capex as a proportion of GDP and present these

scenarios. In the second part of this document (see page 9) we look at the prospects

for housing to pick up and replace the capex from mining which seems to be the RBAs base case.

Capex Scenarios

For each scenario we show our assumptions to the right of the graph.

% of Floating LNG projects imported: This shows our assumption on how much of

a floating LNG projects capex will be imported. Our understanding of the way floating LNG projects will be accounted for by the Australian Bureau of Statistics is best

illustrated by an example. Assume a 4 year project that will spend $4b per annum in

Malaysia and $1b in Australia. Each year the full $5b would appear in mining capex

and there would be an offseting $4b in imports. Therefore mining capex figures are

likely to overstate the effect on the Australian economy for LNG projects.

Now, this is true also of existing mining projects but for existing projects the split

between Australian capex and imported capex is generally heavily skewed toward

Australian capex whereas for floating LNG the skew is the other way around. Our

assumption is that somewhere between 80 and 90% of a floating LNGs capex is imported, which would mean that including all of an LNGs capex would be overstating its effect by between 5 and 10 times.

This means that the headline capex will be skewed by floating LNG imports and so we provide two estimates in each graph one showing the headline capex and one showing the capex net of floating LNG imports.

Ideally we would adjust both forecasts and historical capex estimates to net out

imports for all projects, but the data is not available. It is worth noting though that the

mining peak we see now in Australian Bureau of Statistics is probably overstated by

at least 0.5% due to the effect of imports.

Base Case: % of projects in feasibility going ahead before 2016: This shows our

assumption of the proportion of the dollar value of projects which have a feasibility

study completed that go ahead before 2016. i.e. if there are $10b of projects and we

have a 80% then we assume that $8b of projects go ahead before 2016.

Discounts to Base Case: These are discounts to the base case numbers above that

we apply depending on the projects characteristics. We apply discounts to greenfield projects (i.e. brand new projects are considered less likely than expansions of existing

projects); to projects based on the size of the company (i.e. smaller companies are

less likely to go ahead with a project) and pre-feasibility projects (i.e. projects without

a feasibility study yet are less likely to go ahead before 2016).

Other assumptions (not shown): For all scenarios we use an assumption of 4%

nominal GDP growth for comparability in reality the more bullish scenarios would see greater GDP growth and the more bearish would see less. We assume all

projects which are at the committed stage go ahead. We make assumptions as to the

average construction length depending upon the project type, generally 2 years for

most projects and 4 years for LNG projects. While there are unlikely to be new

projects not currently on the BREE list that start construction in 2013 or 2014 (due to

the long lead time for financing, environments approvals, feasibility studies etc), there

will likely be projects in 2015 or 2016 that we havent yet heard of. We assume an additional 2.5% increase in 2015 and 5% in 2016 to account for these projects in all

scenarios.

8 April 2012

Economic Strategy



Mega Projects going ahead: Due to their size, we make specific assumptions about

13 of the largest projects: Browse LNG, Arrow LNG Plant (trains 1 and 2), Dudgeon

Point, Sunrise Gas project, Scarborough FLNG, Gorgon (train 4), Alpha Coal Project,

Roy Hill, China First Coal project (Galilee Coal Project), West Pilbara, Carmichael

Coal Project (mine and rail), Wandoan opencut (phase 1), Olympic Dam project. For

these projects we simply switch on or off rather than applying discount factors.

FIGURE 2: SUPER BULL



% of Floating LNG projects imported

85%

Base Case:

% projects in feasibility

going ahead before 2016 100%



- Greenfield Projects 0%

- Mid Tier Miner 0%

- Junior Miner 0%

- No Feasibility Study 0%

Mega Projects going ahead before

2016: All.

FIGURE 3: EXTENDED BOOM




85%

Base Case:


90%




- Mid Tier Miner 0%

- Junior Miner 0%


Mega Projects going ahead before 2016: Browse, Arrow (T1+2),

Dudgeon, Sunrise, Scarborough, Gorgon (T4), Alpha Coal, Roy Hill, Galilee Coal, Carmichael Coal.

The (grossly unrealistic) assumption that

all projects go ahead would result in

another leg up to the mining boom

Next we add a little more realism we pull out the major publicly delayed projects like Olympic Dam, Wandoan

etc, assume 90% of feasibility projects go ahead by 2016.

We apply a 25% discount for no feasibility study

The result is an extended boom

with capex around this years

level until 2015

8 April 2012

Economic Strategy



FIGURE 4: SMOOTH LANDING




85%

Base Case:






- Mid Tier Miner 0%

- Junior Miner 0%



2016: Browse, Dudgeon, Sunrise, Scarborough, Gorgon (T4), Alpha Coal, Roy Hill, Galilee Coal,

Carmichael Coal.

FIGURE 5: GREENFIELD / BROWNFIELD ADJUSTMENT




85%

Base Case:






- Mid Tier Miner 0%

- Junior Miner 0%




Carmichael Coal.

Next we double those effects, assuming 80% of

feasibility projects go ahead by 2016, apply a 50%

discount for no feasibility study, and assume no Arrow.

Many of these might still go ahead, just not before 2016.

The result is a relatively smooth path

from 2013-2015 with a more

precipitous drop in 2016 (especially on

the LNG adjusted line)

Then we add a 20% discount to

greenfield (i.e. brand new as opposed to

expansion) projects which slightly

steepens the line

8 April 2012

Economic Strategy



FIGURE 6: BASE CASE




85%

Base Case:







- Junior Miner -50%




Carmichael Coal.

FIGURE 7: LNG BEAR




85%

Base Case:


80%





- Junior Miner -50%


Mega Projects going ahead before 2016: Dudgeon, Alpha Coal, Roy Hill,

Galilee Coal, Carmichael Coal.

Finally to get to our base case we add a 20% discount to projects

by mid-tier miners and a 50% discount to projects by junior miners. As

an example for a junior miner with no feasibility study and a

greenfield project we use 18% of the value of the project.

Assumes base case but no more

LNG approvals (committed

projects still go ahead)

8 April 2012

Economic Strategy



FIGURE 8: COAL BEAR




85%

Base Case:







- Junior Miner -50%



2016: Browse, Sunrise, Scarborough, Gorgon (T4), Roy Hilll.

FIGURE 9: FUNDING SQUEEZE BEAR




85%

Base Case:


80%





- Junior Miner -90%


Mega Projects going ahead before 2016: Browse, Dudgeon, Sunrise,

Scarborough, Gorgon (T4), Alpha Coal, Galilee Coal, Carmichael Coal.

Assumes base case but no more Coal

approvals (committed projects still go

ahead)

Assumes base case but a 50%

discount to mid-tier and 90%

discount for junior projects. No Roy

Hill.

8 April 2012

Economic Strategy



FIGURE 10: DELAYED PROJECT BEAR




85%

Base Case:







- Junior Miner -50%




Carmichael Coal.

FIGURE 11: SUPER BEAR




85%

Base Case:


60%





- Junior Miner -90%


Mega Projects going ahead before 2016: None.

CONCLUSION

Our assessment of mining capex is:

from 1987 to 2005 mining capex varied between 1 and 2% of GDP, with an average of about 1.5% of GDP.

Since 2009 mining capex increased from below 3% to over 6.5% of GDP, adding about 1.5% to GDP growth per year for the last 3 years.

While 2013 is not likely to see major declines, we expect to see declines in

Then we look at the case when only 60% of

projects in feasibility make it to market by

2016.

Finally we add all of the above bear cases

8 April 2012

Economic Strategy



capex of about 1 to 1.5% of GDP from 2014-2016.

Going forward there are likely to be a large number of projects that are deferred:

o Commodity prices have largely peaked. While there is scope for costs to

reduce, we believe this will be a longer term story especially while the Australian dollar remains high. Net effect is planned mining projects are

generally likely to be less profitable than thought 12 months ago.

o major resource companies have largely all had new CEOs installed, with

a mandate for shareholder returns rather than growth

o junior resource companies are struggling to get finance

There are scenarios where mining capex stays high, the key assumptions being a number of LNG projects and whether they will be floating or on-shore.

o In our analysis we assume that Browse , Sunrise and Scarborough all go

ahead but are floating LNG rather than fixed and that Arrow LNG trains 1

and 2 are deferred / merged with other projects.

o If all are deferred then mining capex will fall faster and would be looking

like declining to 2.7% of GDP by 2016

The net result is that the mining capex cliff represents a real risk to growth. Even if mining capex falls to double its longer term history, it will still detract over 3-4%

from GDP over the next few years.

8 April 2012

Economic Strategy



Can Housing Takeover?

A frequent theme in RBA documents is that the housing construction market will

take over from the mining capex boom. In the following charts we explore this theme and conclude that while housing certainly has the scope to ease the transition,

housing does not have the scope to achieve this on its own (even taking into account

that housing has a higher multiplier effect on the rest of the economy) and can

probably at best only make up around 1% (as a % of GDP) of the 3-4% shortfall that

falling mining capex will create.

FIGURE 12: HOUSING APPROVALS PER 1,000 PEOPLE

FIGURE 13: HOUSING INTEREST / DISPOSABLE INCOME

Source: ABS, RBA

Housing approvals look depressed

compared to the last 40 years

The bullish argument says that

this could easily increase back

to the 8-9 range i.e. 50% higher (including population

growth) than current levels

Falling interest rates

have led to improved

affordability

8 April 2012

Economic Strategy



FIGURE 14: HOUSING APPROVALS PER 1,000 PEOPLE 1980-2000

FIGURE 15: HOUSING DEBT TO DISPOSABLE INCOME

FIGURE 16: VALUE OF NEW HOME APPROVALS + ALTERATIONS

Source: The Hague: Ministry of the Interior and Kingdom Relations, FRED Economic Data, ABS, RBA

A more extreme example would see

levels halve and still be consistent

with the UK, Italy from 1980-2000

If Australia declined to the likes of

Germany, Austria, France then maybe the

current level (of just under 7 starts per

1,000) is already above average?

The bearish argument says higher population

growth countries like Australia and the US

have long had housing approvals that were

well above most other developed countries

so an increase in housing starts will depend

on immigration policies (given low birth rates)

And you will need a magnifying

glass if you want to find signs of

deleveraging in Australia which means little scope for extra debt

and is another reason why building

approvals are unlikely to reach the

highs of previous cycles

While looking at the interest

paid shows affordability

improving, this is a function

of low interest rates

debt levels increased 5-6x

over the last 20 years

Which suggests to me that with

lower population growth and high

debt burdens that new home

building will probably struggle to add

1% to GDP growth

4% of GDP seems to be the top of

the cycle for new home building

8 April 2012

Economic Strategy



CONCLUSION

The net effect is that the end of the mining capex boom will likely deduct 3-4% from

Australian GDP over the next three years. Without a pickup in other areas this would

likely mean a recession. There are five main areas that can pick up:

Residential building, but appears unlikely to be able to pick up more than

1% (and maybe closer to 0.5%) of GDP. Appears to need even lower interest

rates, maybe some changes in development restrictions.

Government spending: The most logical source given low interest rates,

but given the fixation on government debt in the last few election campaigns

at both state and federal levels, public capex would appear to be unlikely to

add much (if any) to fill the gap.

Household consumption: Households are still quite leveraged and do not

appear willing to take on more debt, consumption appears unlikely to grow

much faster than the rate of household income growth.

Non Mining Capex: Current capex levels and plans are negative. To get this

part of the economy moving a much lower Australian dollar and / or interest

rates are needed.

Net Exports: Mining exports will help, however increased volumes are being

offset by lower commodity prices. To get this part of the economy moving a

much lower Australian dollar is needed.

The key factor we are watching is the Australian dollar at the US80c level other sectors will be affected, but without exchange rate relief it is hard to see where the

growth can come from.

Date

Economic Strategy


Equities Research Economic Strategy - Tactical Asset Allocation 12

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quantstrategy20130523-choose your own adventure capex cliff edition.pdf

Documents

greenfield projects

floating lng projects

mega projects

types of projects

state of mining projects

capex cliff edition

headline capex

years mining capex